Copyright 2008 The McGraw-Hill Companies Introduction to Economic Growth and Instability

Copyright 2008 The McGraw-Hill Companies 7-2 Learning objectives In this chapter students will learn:In this chapter students will learn: 1.How economic growth is measured and why it is important. 2.About the business cycle and its primary phases. 3.How unemployment and inflation are measured. 4.About the types of unemployment and inflation and their various impacts.

Copyright 2008 The McGraw-Hill Companies 7-3 Economic Growth-how to increase the economy’s productive capacity over time. Two definitions of economics growth are given. 1.The increase in real GDP, which occurs over a period of time. 2.The increase in real GDP per capita, which occurs over time. This definition is superior if comparison of living standards is desired. For example, China’s 2003 GDP was $1410 billion compared to Denmark’s $212 billion, but per capita GDP’s were $1110 and $33,750 respectively. 3.Growth in real GDP does not guarantee growth in real GDP per capita. If the growth in population exceeds the growth in real GDP, real GDP per capita will fall. Growth is an important economic goal because it means more material abundance and ability to meet the economizing problem. Growth lessens the burden of scarcity.

Copyright 2008 The McGraw-Hill Companies 7-4 WEF, GCR: 2009/2010

Copyright 2008 The McGraw-Hill Companies 7-5 The “rule of 70” The arithmetic of growth is impressive. Using the “rule of 70,” a growth rate of 2 percent annually would take 35 years for GDP to double, but a growth rate of 4 percent annually would only take about 18 years for GDP to double. (The “rule of 70” uses the absolute value of a rate of change, divides it into 70, and the result is the number of years it takes the underlying quantity to double.)The arithmetic of growth is impressive. Using the “rule of 70,” a growth rate of 2 percent annually would take 35 years for GDP to double, but a growth rate of 4 percent annually would only take about 18 years for GDP to double. (The “rule of 70” uses the absolute value of a rate of change, divides it into 70, and the result is the number of years it takes the underlying quantity to double.) Main sources of growth are: 1.increasing inputs or 2.increasing productivity of existing inputs. About one-third of U.S. growth comes from more inputs.About one-third of U.S. growth comes from more inputs. About two-thirds comes from increased productivity.About two-thirds comes from increased productivity.

Copyright 2008 The McGraw-Hill Companies 7-6 The arithmetic of growth needs to be qualified.The arithmetic of growth needs to be qualified. a.Growth doesn’t measure quality improvements. b.Growth doesn’t measure increased leisure time. c.Growth doesn’t take into account adverse effects on environment or human security. d.International comparisons are useful in evaluating the country’s performance. For example, Japan grew more than twice as fast as U.S. until the 1990s when the U.S. far surpassed Japan. (see Global Perspective 7.1). There is also some tendency for growth rates to move together, reflecting the interdependence of the global economy.

Copyright 2008 The McGraw-Hill Companies 7-7 Selected Growth Rates Source: Economic Report of the President, 2006 U.S. Germany France Japan U.K. Italy Percentage Change (annual rate) GLOBAL PERSPECTIVE

Copyright 2008 The McGraw-Hill Companies 7-8 Overview of the Business Cycle Four phases of the business cycle are identified over a several ‑ year period. (See Figure 7.1) 1.A peak is when business activity reaches a temporary maximum with full employment and near-capacity output. 2.A recession is a decline in total output, income, employment, and trade lasting six months or more. 3.The trough is the bottom of the recession period. 4.The expansion is when output and employment are expanding toward full ‑ employment level.

Copyright 2008 The McGraw-Hill Companies 7-9 The Business Cycle Level of Real Output Time Peak Recession Expansion Trough Growth Trend O 7.1 Phases of the Business Cycle Cyclical Impact: Durables and Nondurables

Copyright 2008 The McGraw-Hill Companies 7-10 What causes the business cycle There are several theories about causation.There are several theories about causation. 1.Major innovations may trigger new investment and/or consumption spending. 2.Changes in productivity may be a related cause of the business cycle. 3.The level of aggregate spending is important, especially changes on capital goods and consumer durables. Cyclical fluctuations: Durable goods output is more volatile than non-durables and services because spending on latter usually can not be postponed.

Copyright 2008 The McGraw-Hill Companies 7-11 Unemployment (One Result of Economic Downturns) Measuring unemployment (see Figure 7.2 for 2005): The population is divided into three groups:The population is divided into three groups: 1.those under age 16 or institutionalized 2.those who are “not in labor force,” (e.g., housewives) and 3.the labor force that includes those age 16 and over who are willing and able to work, and actively seeking work (demonstrated job search activity within the last four weeks). The unemployment rate is defined as the percentage of the labor force that is not employed. (Note: Emphasize not the percentage of the population.)The unemployment rate is defined as the percentage of the labor force that is not employed. (Note: Emphasize not the percentage of the population.) The unemployment rate is calculated by random survey of 60,000 households nationwide. (Note: Households are in survey for four months, out for eight, back in for four, and then out for good; interviewers use the phone or home visits using laptops.)The unemployment rate is calculated by random survey of 60,000 households nationwide. (Note: Households are in survey for four months, out for eight, back in for four, and then out for good; interviewers use the phone or home visits using laptops.)

Copyright 2008 The McGraw-Hill Companies 7-12 The unemployment rate is defined as the percentage of the labor force (not of population) that is not employed. Unemployment rate unemployed labor force x 100 =

Copyright 2008 The McGraw-Hill Companies 7-13 Unemployment Under 16 And/or Institutionalized (70.5 Million) Labor Force, Employment, and Unemployment, 2005 Total Population (296.6 Million) Not in Labor Force (76.8 Million) Employed (141.7 Million) Labor Force (149.3 Million) Unemployed (7.6 Million)

Copyright 2008 The McGraw-Hill Companies 7-14 Two factors cause the official unemployment rate to understate actual unemployment. a.Part ‑ time workers are counted as “employed.” b.“Discouraged workers” who want a job, but are not actively seeking one, are not counted as being in the labor force, so they are not part of unemployment statistic. Types of unemployment: 1.Frictional unemployment: consists of those searching for jobs or waiting to take jobs soon; it is regarded as somewhat desirable, because it indicates that there is mobility as people change or seek jobs. Types: Voluntarily moving from one job to anotherVoluntarily moving from one job to another Fired and seeking another jobFired and seeking another job Housewives who decided to workHousewives who decided to work New graduates looking for jobs for the first timeNew graduates looking for jobs for the first time Note: this type of unemployment is inevitable

Copyright 2008 The McGraw-Hill Companies Structural unemployment: due to changes in the structure of demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs changes. Examples of structural unemployment: a.Glass blowers were replaced by bottle-making machines. b.Oil-field workers were displaced when oil demand fell in 1980s. c.Airline mergers displaced many airline workers in 1980s. d.Foreign competition has led to downsizing in U.S. industry and loss of jobs. e.Military cutbacks have led to displacement of workers in military-related industries. Difference between frictional and structural unemployment is that frictional unemployed have salable skills, but structurally unemployed will find it difficult to find a job

Copyright 2008 The McGraw-Hill Companies Cyclical unemployment is caused by the recession phase of the business cycle. a.As firms respond to insufficient demand for their goods and services, output and employment are reduced. b.Extreme unemployment during the Great Depression (25 percent in 1933) was cyclical unemployment. It is sometimes not clear which type describes a person’s unemployment circumstances.It is sometimes not clear which type describes a person’s unemployment circumstances.

Copyright 2008 The McGraw-Hill Companies 7-17 Definition of “Full Employment” Full employment does not mean zero unemployment.Full employment does not mean zero unemployment. The full ‑ employment unemployment rate is equal to the total frictional and structural unemployment. The full ‑ employment rate of unemployment is also referred to as the natural rate of unemployment NRU.The full ‑ employment unemployment rate is equal to the total frictional and structural unemployment. The full ‑ employment rate of unemployment is also referred to as the natural rate of unemployment NRU. The natural rate is achieved when labor markets are in balance; the number of job seekers equals the number of job vacancies. The natural rate of unemployment is not fixed but depends on the demographic makeup of the labor force and the laws and customs of the nations.The natural rate is achieved when labor markets are in balance; the number of job seekers equals the number of job vacancies. The natural rate of unemployment is not fixed but depends on the demographic makeup of the labor force and the laws and customs of the nations. Recently the natural rate has dropped from 6% to 4 to 5%. This is attributed to:Recently the natural rate has dropped from 6% to 4 to 5%. This is attributed to: a.The aging of the work force as the baby boomers approach retirement. b.Improved job information through the internet and temporary-help agencies. c.New work requirements passed with the most recent welfare reform. d.The doubling of the U.S. prison population since 1985.

Copyright 2008 The McGraw-Hill Companies 7-18 Economic cost of unemployment: GDP gap and Okun’s Law: GDP gap is the difference between potential and actual GDP. (See Figure 7.3) Economist Arthur Okun quantified the relationship between unemployment and GDP as follows: For every 1 percent of unemployment above the natural rate, a negative GDP gap of about 2 percent occurs. This is known as “Okun’s law”GDP gap and Okun’s Law: GDP gap is the difference between potential and actual GDP. (See Figure 7.3) Economist Arthur Okun quantified the relationship between unemployment and GDP as follows: For every 1 percent of unemployment above the natural rate, a negative GDP gap of about 2 percent occurs. This is known as “Okun’s law” Unequal burdens of unemployment exist. (See Table 7.3)Unequal burdens of unemployment exist. (See Table 7.3) 1.Rates are lower for white ‑ collar workers. 2.Teenagers have the highest rates. 3.African-Americans have higher rates than whites. 4.Rates for males and females are comparable, though females had a lower rate in Less educated workers, on average, have higher unemployment rates than workers with more education.

Copyright 2008 The McGraw-Hill Companies 7-19 Unemployment Actual and Potential GDP and the Unemployment Rate The GDP Gap 12,000 11,000 10,000 9,000 8,000 7,000 6,000 5,000 GDP (billions of 1996 dollars) The Unemployment Rate Unemployment (percent of civilian Labor force) Source: Congressional Budget Office & Bureau of Economic Analysis GDP gap (positive) GDP gap (negative) Potential GDP Actual GDP

Copyright 2008 The McGraw-Hill Companies 7-20 Noneconomic costs include loss of self ‑ respect and social and political unrest.Noneconomic costs include loss of self ‑ respect and social and political unrest. International comparisons. (See Global Perspective 7.2)International comparisons. (See Global Perspective 7.2)

Copyright 2008 The McGraw-Hill Companies 7-21 Unemployment Source: Bureau of Labor Statistics U.S. Germany Italy Japan France Unemployment Rate (percent) Unemployment Rates in Five Industrial Nations, GLOBAL PERSPECTIVE

Copyright 2008 The McGraw-Hill Companies 7-22 Task 2: UNEMPLOYMENT IN KUWAIT 1.Collect data about unemployment in Kuwait 2.What are the main trends of unemployment 3.Why do we have such a problem 4.What can we do to moderate unemployment

Copyright 2008 The McGraw-Hill Companies 7-23 Inflation: Defined and Measured Definition: Inflation is a rising general level of prices (not all prices rise at the same rate, and some may fall). The main index used to measure inflation is the Consumer Price Index (CPI).Definition: Inflation is a rising general level of prices (not all prices rise at the same rate, and some may fall). The main index used to measure inflation is the Consumer Price Index (CPI). To measure inflation, subtract last year’s price index from this year’s price index and divide by last year’s index; then multiply by 100 to express as a percentage.To measure inflation, subtract last year’s price index from this year’s price index and divide by last year’s index; then multiply by 100 to express as a percentage. The main index used to measure inflation is the Consumer Price Index (CPI). Measuring Inflation: the percentage change in CPI  2002 CPI = 123  2003 CPI – 127  Inflation = (( )/123)% = 3.25% “Rule of 70” permits quick calculation of the time it takes the price level to double: Divide 70 by the percentage rate of inflation and the result is the approximate number of years for the price level to double.“Rule of 70” permits quick calculation of the time it takes the price level to double: Divide 70 by the percentage rate of inflation and the result is the approximate number of years for the price level to double. If the inflation rate is 7 percent, then it will take about ten years for prices to double. (Note: You can also use this rule to calculate how long it takes savings to double at a given compounded interest rate).If the inflation rate is 7 percent, then it will take about ten years for prices to double. (Note: You can also use this rule to calculate how long it takes savings to double at a given compounded interest rate).

Copyright 2008 The McGraw-Hill Companies 7-24 Facts of inflation:Facts of inflation: 1.In the past, deflation has been as much a problem as inflation. For example, the 1930s depression was a period of declining prices and wages. The prospect of deflation was a concern of economic policymakers earlier this decade. 2.All industrial nations have experienced the problem (see Global Perspective 7.3). 3.Some nations experience astronomical rates of inflation (Zimbabwe is a recent case). For more details Visit my blog: Economic Notes: 4.The inside covers of the text contain historical rates for the U.S.

Copyright 2008 The McGraw-Hill Companies 7-25 Causes and theories of inflation:Causes and theories of inflation: 1.Demand ‑ pull inflation: Spending increases faster than production. It is often described as “too much spending chasing too few goods.” 2.Cost ‑ push or supply ‑ side inflation: Prices rise because of rise in per-unit production costs (Unit cost = total input cost/units of output). a.Output and employment decline while the price level is rising. b.Supply shocks have been the major source of cost-push inflation. These typically occur with dramatic increases in the price of raw materials or energy. 3.Complexities: It is difficult to distinguish between demand ‑ pull and cost ‑ push causes of inflation, although cost ‑ push will die out in a recession if spending does not also rise.

Copyright 2008 The McGraw-Hill Companies 7-26 Inflation Annual Inflation Rates in the United States, Inflation Rate (percent) Source: Bureau of Labor Statistics

Copyright 2008 The McGraw-Hill Companies 7-27 Inflation Source: Bureau of Labor Statistics U.S. Germany Italy Japan France Inflation Rate (percent) Inflation Rates in Five Industrial Nations, GLOBAL PERSPECTIVE

Copyright 2008 The McGraw-Hill Companies 7-28 Redistributive effects of inflation: The price index is used to deflate nominal income into real income.The price index is used to deflate nominal income into real income. Inflation may reduce the real income of individuals in the economy, but won’t necessarily reduce real income for the economy as a whole (someone receives the higher prices that people are paying).Inflation may reduce the real income of individuals in the economy, but won’t necessarily reduce real income for the economy as a whole (someone receives the higher prices that people are paying). Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects.Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects. Fixed ‑ income groups will be hurt because their real income suffers. Their nominal income does not rise with prices.Fixed ‑ income groups will be hurt because their real income suffers. Their nominal income does not rise with prices. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power.Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power.

Copyright 2008 The McGraw-Hill Companies 7-29 Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender.Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender. If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders.If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders. “Inflation premium” is amount that interest rate is raised to cover effects of anticipated inflation.“Inflation premium” is amount that interest rate is raised to cover effects of anticipated inflation. “Real interest rate” is defined as nominal rate minus inflation premium. (See Figure 7.5)“Real interest rate” is defined as nominal rate minus inflation premium. (See Figure 7.5) Effects of inflation are arbitrary, regardless of society’s goals.

Copyright 2008 The McGraw-Hill Companies 7-30 Inflation Anticipated Inflation –Nominal Interest Rate –Real Interest Rate –Inflation Premium Nominal Interest Rate Real Interest Rate Inflation Premium 11% 5% 6% =+ O 7.2

Copyright 2008 The McGraw-Hill Companies 7-31 Output Effects of Inflation Cost ‑ push inflation, where resource prices rise unexpectedly, could cause both output and employment to decline. Real income falls.Cost ‑ push inflation, where resource prices rise unexpectedly, could cause both output and employment to decline. Real income falls. Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous economy, or it may have an undesirable impact on real income.Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous economy, or it may have an undesirable impact on real income. Danger of creeping inflation turning into hyperinflation, which can cause speculation, reckless spending, and more inflation (see examples in text of Japan following World War II, and Germany following World War I).Danger of creeping inflation turning into hyperinflation, which can cause speculation, reckless spending, and more inflation (see examples in text of Japan following World War II, and Germany following World War I).

Copyright 2008 The McGraw-Hill Companies 7-32 The Stock Market and the Economy Supply and Demand in the Stock MarketSupply and Demand in the Stock Market Collective Expectations of Future Profits and LossesCollective Expectations of Future Profits and Losses Dow Jones Industrial Average (DJIA)Dow Jones Industrial Average (DJIA) Volatility of the Stock MarketVolatility of the Stock Market Wealth EffectWealth Effect Investment EffectInvestment Effect Studies Show Consumption and Investment UnaffectedStudies Show Consumption and Investment Unaffected Little Impact on MacroeconomyLittle Impact on Macroeconomy Stock Market Bubbles Do Have an ImpactStock Market Bubbles Do Have an Impact Stock Price Cycle PredictionsStock Price Cycle Predictions Index of Leading IndicatorsIndex of Leading Indicators Stock Prices Not a Reliable Predictor AloneStock Prices Not a Reliable Predictor Alone Last Word Do Stock Prices Affect Macroeconomic Instability?

Copyright 2008 The McGraw-Hill Companies 7-33 Key Terms economic growth real GDP per capita rule of 70 productivity business cycle peak recession trough expansion labor force unemployment rate discouraged workers frictional unemployment structural unemployment cyclical unemployment full-employment rate of unemploymentfull-employment rate of unemployment natural rate of unemployment (NRU)natural rate of unemployment (NRU) potential output GDP gap Okun’s law inflation Consumer Price Index (CPI) demand-pull inflation cost-push inflation per-unit production costs nominal income real income anticipated inflation unanticipated inflation cost-of-living adjustments (COLAs) real interest rate nominal interest rate deflation hyperinflation

Copyright 2008 The McGraw-Hill Companies 7-34 Next Chapter Preview… Basic Macroeconomic Relationships